WTF Is a Yield Curve?

August 14, 2019

Cheddar's Nora Ali explains the yield curve for treasury bonds, the figures that had traders spooked during the big stock selloff on Wednesday.


Nora Ali: You've been watching the markets recently,

Nora Ali: you've probably heard a lot about yield curves.

Nora Ali: And on Wednesday, something happened that

Nora Ali: made the topic long watched by

Nora Ali: bond experts but rarely talked about by

Nora Ali: casual investors particularly interesting.

Nora Ali: The yield curve inverted,

Nora Ali: and it's really spooked the markets.

Nora Ali: But the big question is, why?

Nora Ali: But before we get into that,

Nora Ali: let's talk about what's the yield curve actually is.

Nora Ali: Basically, the plot of how much investors get

Nora Ali: paid or the yield for

Nora Ali: holding a bond for different lengths of time,

Nora Ali: otherwise known as maturities.

Nora Ali: So this is what a yield curve normally looks like.

Nora Ali: On the bottom are the time periods anywhere

Nora Ali: from one month all the way to 30 years,

Nora Ali: and then along the side are those yields.

Nora Ali: Since a treasury bond is essentially

Nora Ali: a loan to the US governments,

Nora Ali: there's usually less risk in lending out

Nora Ali: money for shorter periods of time.

Nora Ali: After all, you're probably pretty convinced

Nora Ali: that you're going to be paid back.

Nora Ali: You usually get paid a lower yield

Nora Ali: here for shorter maturities,

Nora Ali: and then looking out further in the future,

Nora Ali: say 10 or 30 years,

Nora Ali: you're much less certain of what could

Nora Ali: happen, new political policy's,

Nora Ali: a market crash, a war, you name it,

Nora Ali: so you'd usually demand to get paid much more for that.

Nora Ali: And that is why the curve usually slopes upwards.

Nora Ali: Now, let's take a look at

Nora Ali: the yield curve looks like today.

Nora Ali: Looks a little something like this.

Nora Ali: Investors seem much more

Nora Ali: concerned about the short term ability of

Nora Ali: the government to meet its debt obligations. But why?

Nora Ali: You can blame anything from the US-China trade war,

Nora Ali: to uncertainty over what

Nora Ali: the Fed will do with interest rates,

Nora Ali: to even questions about the campaign policies

Nora Ali: from all the people running in 2020.

Nora Ali: And with all the volatility in the stock market recently,

Nora Ali: investors are clamoring for

Nora Ali: safer investments like longer term bonds,

Nora Ali: that's sending those prices

Nora Ali: up and sending those yields down.

Nora Ali: Now, one particular part of

Nora Ali: the yield curve is particularly troubling

Nora Ali: and that's this section here between

Nora Ali: the 2 and 10 year Treasuries.

Nora Ali: Over the last couple of weeks,

Nora Ali: the line connecting those yields has been flattening.

Nora Ali: And here's another way to look at it.

Nora Ali: This is the difference here or spread

Nora Ali: between the 10 and 2 year Treasury yields.

Nora Ali: It's been falling sharply

Nora Ali: in August as you can see right there.

Nora Ali: And on Wednesday, it actually went negative.

Nora Ali: Here's that same spread since 2007.

Nora Ali: The last time it went below zero was

Nora Ali: right before the financial crisis.

Nora Ali: You might remember what that was like.

MALE_1: Now, tumbled more than 500 points

MALE_1: after two pillars of the Street tumbled over the week.

FEMALE_1: Lehman Brothers has filed for bankruptcy.

FEMALE_2: Stocks all around the world are

FEMALE_2: tanking because of the crisis on Wall Street.

George W. Bush: We're in the midst of a serious financial crisis.

Nora Ali: And the spread has dropped below zero a

Nora Ali: couple of times over the past several decades.

Nora Ali: So here's a look since the early '90s and

Nora Ali: the bar graph here is US GDP.

Nora Ali: You can see whenever the spread has gone negative,

Nora Ali: like there and there,

Nora Ali: so does GDP, meaning the economy goes into recession.

Nora Ali: So this here was the financial crisis,

Nora Ali: and this here was the dot-com bust.

Nora Ali: Neither was very fun for anyone

Nora Ali: whether they were in the stock market or not.

Nora Ali: On average, you can see the recession about two

Nora Ali: years after the yield curve flip flops.

Nora Ali: Now, it's probably too soon to say that

Nora Ali: this week's inversion means

Nora Ali: the economy is definitely going to crash,

Nora Ali: but the bond markets certainly seem worried.

Nora Ali: And if things continue on the current route,

Nora Ali: it could have a big impact on investors,

Nora Ali: the global economy, and even the 2020 race.

Nora Ali: Regardless of the actual economic or political outcome,

Nora Ali: an inverted curve could yield some interesting results.